December 4, 2007

maintenance capex and FCF

I received the following question from sanjay shetty via email. I will try to answer the question and have also simplified it via several assumptions

You mentioned you "use maintenance capex needed to support unit volumes or competitive position (maintenance capex)."

I downloaded your Excel sheets couldn't figure out the basis for calculation of the same, especially as companies don't give break ups of maintenance capex. If you could explain would be great.
Maybe my understanding is incorrect, however I feel that all Purchase of Fixed assets should be deducted from Free Cash Flow especially when the amount out there is a yearly spend by the company to grow it's business.

Let me start with the following definition for free cash flow (paraphrased) as given by warren buffet

Free cash flow = Net earnings + depreciation – maintenance capex

Now you can take the above formulae as a given or debate whether it is correct. I think it is correct as free cash flow is basically discretionary cash which the owners (actually managers on their behalf) of the business can choose whichever way to invest. It is discretionary cash because the business is left with this cash after it has incurred the required capex to maintain its current position in terms of volume and competitive position. If it does not do that, then the business will start degrading and may eventually be wiped out.

Now the discretionary cash can be spent in the following ways

1. Invest in the buiness itself if the returns are good – most common approach. Value adding if the business earns more than cost of capital . for ex: ITC, asian paints, HLL etc. This investment is in fixed assets and working capital
2. Accquire other company – Eg. Marico
3. Return cash to shareholder via dividends or share buyback
4. Just hold cash and do nothing – Ex: Merck, Novartis etc

Now the question – How to calculate maintenance capex? There is no precise formulae for that. The best you can do is to arrive at a rough number as companies don’t give this number. Let take the definition above and let me give my approach

If the maintenance capex is to maintain unit volumes, then value sales would be growing at the rate of inflation. So lets take a hypothetical case (simplified)

Sales = 100
Return on equity = 20% ( debt = 0)
Net margin = 10%
Total asset / sales = 2
Total asset = 50
Depreciation = 5 % of asset

Now in year 2
Sales = 105 (5 % inflation)
ROE = 20%
Net margin = 10%
Total asset / sales = 2
Total asset = 52.5
FCF = 10.5+2.5-2.5 [ asset increase = 2.5 ]

So in the simple case above FCF is equal to Net profit. Ofcourse reality is not so simple. However once you get an idea of the basic concept, you can do a rough estimation of the maintenance capex and free cash flow.

Key point to remember – If the ROE is in excess of 15%, generally the depreciation will covers the maintenance capex and the Net profit will be almost equal to free cash flow.

Exception to the above can be seen in some companies such as Gujarat gas/ HLL etc where the Working capital throws off cash and hence the FCF is actually greater than the free cash flow.

So in response to the question above, I would say that some amount of the Fixed asset has to be adjusted , but I would not deduct all the addition. For ex: A company launches a very profitable product and due to volume growth puts up a new plant. The cash flow may be negative during that year and then become positive a few years later. If you focus on the cash flow based on actual capex, you may undervalue the company when it is investing in a profitable venture and over value a company which is not investing and just milking its assets.

The above post may appear fairly academic and boring, but I think the question asked by sanjay goes to the core of how to value a company.
Next post : I will try to explain how I calculate FCF using the excels I have uploaded


VISHNU said...


This article is not boring..good and stimulting intellectually.

But I dont understand the point "FCF is actually greater than the free cash flow"


value investor india said...

This is a link which explains in lucid terms the difference b/w growth and maintenance capex for Walmart.

value investor india said...


What should we do with increase in working capital shown in cash flow statement?

When the sales of a company are increasing the working cap would increase too leading to lower operating cash flows.

Is it prudent to breakdown working capital b/w growth and maintenance by taking average of net current assets to sales ratio over last 5 years and then adjusting for any increase?


Joe said...

Rohit - Can you help clarify this statement 'If the ROE is in excess of 15%, generally the depreciation will covers the maintenance capex and the Net profit will be almost equal to free cash flow'. Not sure I understand why ROE has to be greater than 15% for depr = maintenance capex.

Anonymous said...

Hi Rohit,

Very nice post. I was about to ask you to clarify the very same points but sanjay beat me to it. Some of my other queries have also been already asked in the comments above. Do asnwer them when you can. And thanks for the posts, you're doing a great job!


Rohit Chauhan said...

Hi vishnu

thats a typo. It should be FCF is actually greater than the net profit"

Bhavesh - thats a good link. the post explains maintenance v/s growth capex very well using walmart as an example.

Wcap should be treated in the same way as Fixed asset. Inflation would cause an increase in Wcap even if the unit volumes remain the same. So I would consider Wcap as a part of maintenance capex. One way could be as you have pointed out. The other way would be to look at the WCAP turns the business gets and to use that to estimate the WCAP required for sales increase (inflation based) while keeping the unit volumes same.

Mark, joe and bhavesh - I will try to elaborate on the above point and joe’s question more in my next post.

I am sorry for being short on explaination and detail on my post and comments as it is difficult to answer the question without making a lot of assumptions

For ex: In discussing about Maintenance capex I have discussed the relationship of ROE and capex. But Asset turns have an equal or bigger role. Asset heavy businesses require more maintenance capex than asset light business (ofcourse ..all other things being equal :) )

Prem Sagar said...

Just wondering if you ever thought of setting up your blog on your own domain instead of blogger.

It cost me only 20$ per yr. (of course, space is only 50MB...u can buy space for cheap).

I guess you really need to move up the blogging ladder and add a touch of professional make-up. Your blog deserves much more.

The other thing is you need to give a thought about aesthetics. I guess if you take care of this, your blog will rock!!

Again, this is my own opinion and I might be wrong!!

(now moved to

Rohit Chauhan said...

hi prem
just saw your website. pretty well done.
i have been thinking of it for sometime, but still need to make up my mind. can you send me your email id to my id -, just wanted to discuss the mechanics of how you have gone about it

muthu said...

A General Observation. Dont find a place, so putting here.

Your blogs are going more & more into deep company analysis. I remember reading even last year talking about terms related to Market.
As a person in moderate level into the value investing, I find the discussion is going more deeper & away from the market.

Currently, iam only doing investment analysis rather than applying those to a buy, due to market height.

I feel you should also include articles which illustrate the wrong doings of Value investors. Otherwise, it would be only pride for value investing and not much in natural path of "fall and raise".

Rohit Chauhan said...

hi muthu
i am not sure if i understand you comment completely. if you refer to lack of market analysis, i think it by design and less by accident.
i personally do not have any special insight on the market and cannot remotely predict. over time i have realised it is more profitable to my portfolio to analyse companies than to analyse the market or try predicting it.
also my personal focus is on value investing, it is not with the aim to prove that it is the only and most successful form of investing. It is just that i am more comfortable with it and could not give any useful ideas on other forms of investing
in terms of negatives, i think investors following value investing or other forms suffer from similar problems. i think it is more to do with the individual investor than with the philosophy of investing